Topic 4: The Firm’s Capital Structure and degree of leverage

Let’s Discuss
1. Types of Capital
2. External Assessment of Capital Structure
3. Capital Structure Theory
4. Optimal Capital Structure
5. EBIT–EPS Approach to Capital Structure
6. Considering Risk in EBIT–EPS Analysis
7. Basic Shortcoming of EBIT–EPS Analysis
8. Choosing the Optimal Capital Structure

Leverage
• the effects that fixed costs have on the returns that shareholders earn
• higher leverage generally results in higher but more volatile returns
• also refers to a particular cost or expense that is used to generate profit or income to the
company.

Evaluation of Business and Financial Risk

Business risk
 The riskiness inherent in the firm’s operations if it uses no debt.
 These depends on several factors such as
1. Product obsolescence
2. Foreign risk exposure
3. Demand variability.
4. Sales price variability
5. Regulatory risk and legal exposure
6. The extent to which costs are fixed: operating leverage
7. Competition.
8. Input cost variability

OPERATING LEVERAGE
• represents extent of the use of fixed operating costs to magnify the effects of changes in
sales on the firm’s earnings before interest and taxes.
• the risk that the result of the firm’s operation may not be able to cover the fixed cost it
incurred.

Degree of Operating Leverage (DOL)

• Used as a measurement of Operating Leverage
• Formula:

𝐷𝑂𝐿=𝐶𝑀𝐸𝐵𝐼𝑇 𝑜𝑟 %Δ𝐸𝐵𝐼𝑇%Δ𝑆𝑎𝑙𝑒𝑠
FINANCIAL RISK
• the additional risk placed on the common stockholders as a result of the decision to
finance with debt
• may also refer to the risk that the company may not be able to settle its liabilities and
may go bankrupt.

Financial Leverage
• The extent to which fixed-income securities (debt and preferred stock) are used in a
firm’s capital structure
• the use of debt concentrates the firm’s business risk on the stockholders

degree of financial leverage (DFL)

• The numerical measure of the firm’s financial leverage.
• Formula:

𝐷𝐹𝐿=𝐸𝐵𝐼𝑇𝐸𝐵𝑇 𝑜𝑟 %Δ𝑁𝐼%Δ𝐸𝐵𝐼𝑇

TOTAL OR COMBINED RISK

• Represents the combined risk borne by the firm as a consequence of using fixed cost
and financing.

TOTAL LEVERAGE
• The use of fixed costs, both operating and financial, to magnify the effects of changes in
sales on the firm’s earnings per share.

degree of total or combined leverage (DTL)

• represents the extent to which both the fixed cost and interest expenses are incurred
• this is the numerical measure of the firm’s total leverage.
Formula:
𝐷𝑇𝐿=𝐶𝑀𝐸𝐵𝑇 𝑜𝑟 %Δ𝑁𝐼%Δ𝑆𝑎𝑙𝑒𝑠
Relationship of Operating, Financial, and Total Leverage
The relationship between operating leverage and financial leverage is multiplicative rather than
additive.
This relationship is expressed by:

Application of Degree of Leverages:

Mokona has the following forecast for 2020:
Forecast sales in units 50,000.00
Sales price per unit ₱ 40.00
Variable cost per unit ₱ 25.00
Fixed cost:
Manufacturing overhead and ₱ 300,000.00
expenses
Interest expenses ₱ 25,000.00
 a. How much is the Earnings before interest and taxes? 450,000
b. How much is the Earnings after interest and taxes? 425,000
c. What is the Degree of Operating Leverage at 50,000 units? 1.67
d. What is the Degree of Financial Leverage at 50,000 units? 1.06
e. What is the Degree of Total or Combined Leverage at 50,000 units? 1.76

Solution:
Sales ₱ 2,000,000.00
Variable Cost (₱ 1,250,000.00)
Contribution Margin ₱ 750,000.00
Fixed Cost (₱ 300,000.00)
EBIT ₱ 450,000.00
Interest ₱ 25,000.00
Taxes 0
EBT ₱ 425,000.00

Hamada Equation
As the company moves from being unlevered to levered, Increasing the debt ratio increases the
risk that bondholders face and also the cost of debt. Hence, the Beta is adjusted (i.e. under the
CAPM, a firm’s Beta represents its inherent risk in a given market under the assumption that the
firm is unlevered) to capture the relative riskiness of the firm affected.
To compute for the adjusted Beta, the Hamada Equation is utilized:

Application of Hamada Equation:

Smart Co. currently has a capital structure that consists of 40% debt and 60% common equity.
The company has a 40% tax rate. Currently the levered beta ( ) on the company’s stock is 1.4.
a. What is the company’s unlevered beta ( )? 1.0
b. What would be the company’s levered beta ( ) if Smart changed its capital
structure to 20% debt and 80% common equity? 1.15
 a. unlevered beta

Notice that < ; is the firm’s beta if it had no debt. Therefore, the higher the debt
the higher the risk that will in return increase the beta

b. Use the unlevered beta calculated in letter a:

Determining the Optimal Capital Structure

Capital Structure

 The mix of debt, preferred stock, and common equity that is used to finance the firm’s
assets.

Optimal Capital Structure

 The capital structure that maximizes a stock’s intrinsic value.

Firms’ actual capital structures change over time, and for two quite different reasons:

1. Deliberate actions
 Companies may deliberately raise new money in a manner that moves the actual
structure toward the target.
2. Market action
 changes in the market value of the debt and/or equity could result in large changes in
its measured capital structure

Application of the optimal Capital Structure:

Lugia Corp. is trying to determine its optimal capital structure. The following table is
constructed:

The applicable corporate tax rate for the company is 40%. CAPM approach is used to measure
the cost of equity. The risk-free rate is 5% and the market risk premium is 6%. The unlevered
beta is 1.0
 a. What is the weight of debt in the optimal capital structure? 40%
b. What is the weight of equity in the optimal capital structure? 60%
c. What is the WACC on the optimal capital structure? 10.15%

Solution:
Extend the table above:

Analysis:

 The variable K (cost) and r (return) are the same but form different perspective. A rate is
viewed by a firm as cost while this is viewed by an investor as a return.
 Adjusted beta is already given. In the moment it was not given, compute for it using the
Hamada equation and the given unlevered beta of 1.0
 The optimal capital structure is the lowest weighted cost of all the cost of capital the firm
holds.

Considerations in determination of optimal capital structure:

1. Capital Structure Theory

a. This states that the capital structure is irrelevant to the firm’s value or the stock price
b. The assumption under this is that:
i. There are no taxes.
ii. There are no brokerage costs.
iii. There are no bankruptcy costs.
iv. Acquisition of bonds and stocks have the same cost
v. Symmetry of information exist

c. Contradiction of the Capital Structure Theory

i. Taxes
 Pro-debt – interest is tax deductible
 Pro-equity – dividends has lower tax rates; capital gains tend to lower the
required rate of return by investors
ii. Bankruptcy
 The lower the weight of debt in the firm’s capital structure the less risk of
bankruptcy
 2. Trade-off theory
a. This states that the capital structure is relevant to the firm’s value or the stock price
b. The theory that states that firms trade off the tax benefits of debt financing against
problems caused by potential bankruptcy.
c. The firm benefit from higher tax rates which acts as a tax shield

3. Pecking Order Theory

a. This states that the capital structure is relevant to the firm’s value or the stock price
b. This theory states that financing should be in the following order:
i. Internal Financiering - Retained Earnings
ii. External Financing - Debt
iii. External Financing – New Common Stock or Share

4. Signaling Theory
a. A financing action by management that is believed to reflect its view of the firm’s stock
value; generally, debt financing is viewed as a positive signal that management believes
the stock is “undervalued,” and a stock issue is viewed as a negative signal that
management believes the stock is “overvalued.”
b. Asymmetry of Information
i. The situation where managers have different (better) information about firms’
prospects than do investors.
c. Symmetry of Information
i.The situation where investors and managers have identical information about firms’
prospects.

5. Management Empire-building
a. The Board of directors tend to prefer more debt to “prevent” the management from using
the company’s resources for unreasonable perks. Increase in interest expense may keep
management from spending.

EBIT–EPS Approach to Capital Structure

EBIT–EPS approach
 An approach for selecting the capital structure that maximizes earnings per share (EPS)
over the expected range of earnings before interest and taxes (EBIT).

financial breakeven point

 The amount of EBIT necessary to cover all fixed financial costs, namely:
o annual interest (I)
o preferred stock dividends (PD)
 the level of EBIT on which EPS equates to 0
  Formula:

Considering Risk in EBIT–EPS Analysis

Graphically, the risk of each capital structure can be asses in these measures:
(1) the financial breakeven point: EBIT-axis intercept
(2) the degree of financial leverage: the slope of the capital structure line

Example:

Observations:

 the capital structure with 60% debt, when plotted based on hypothetical graph of the
relationship of its EBIT and EPS, has the steepest slope of the three.
 The highest the financial breakeven point is at P50,000 EBIT which tells that the capital
structure with 60% debt is the riskiest
 the capital structure with 60% debt also has the steepest slope of three telling that it
entails greater financial risk
Basic Shortcoming of EBIT–EPS Analysis

 EBIT–EPS analysis tends to concentrate on maximizing earnings rather than maximizing

owner wealth – the firm’s stock price.
 the maximization of EPS does not ensure owner wealth maximization since risk
premiums increase with increases in financial leverage,
 To select the best capital structure, firms must integrate both return (EPS) and risk
(required return)

Choosing the Optimal Capital Structure

The procedures for linking to market value the return and risk associated with alternative capital
structures

Estimating Value
estimate the per-share value of the firm, Po.

Where

 rs = associated required return at the related level of EPS

 Po = per-share value of the firm

Example:

Blue Inc. recently released its financial statements for 2019. The EPS is 2.4. The stockholders of
Blue Inc. expects a 5% required rate of return. Estimate the value of the firm using the EPS
approach.

Maximizing Value Versus Maximizing EPS

The wealth of the owners as reflected in the estimated share value that should serve as the
criterion for selecting the best capital structure however EPS maximization in estimating value of
a firm does not consider risk.

Other important consideration in Capital Structure Decision